Last Thursday, I had the pleasure of listening to Hunt Alcott, Assistant Professor of Economics at NYU, present some new work on the impact of taxation when consumers are inattentive to certain types of price signals.

Earlier in this course we learned about different types of taxes: corrective taxes that “correct” a market failure and increase social welfare and distortionary taxes that raise revenue, but decrease social welfare. Dr. Alcott and co-authors’ provocative hypothesis is that when consumers make mistakes in thinking about different types of prices, you can construct taxes that are not corrective, but nonetheless increase social welfare. Literally, you are taxing people to make them better off. This is “We’re from the government and we’re here to help” taken up a notch.

To understand this hypothesis we need to define the particular type of mistake that consumers are making. This mistake is what the authors call “inattention.” Drawing on the literature, they argue that people are often more price responsive to purchase prices than to other implicit prices or ancillary costs. For example, people are more responsive to purchase price than shipping and handling costs or sales tax rates. They argue that the long run fuel costs associated with operating a vehicle are similar ancillary costs and consumers may be inattentive to these costs when making their car purchase decision.

Under these circumstances, taxing gas-inefficient vehicles, or implicitly taxing them through a CAFE standard, can actually make inattentive people better off. The tax increases the relative purchase price of the gas-guzzler and decreases the relative purchase price of the fuel-efficient car. The tax distorts relative prices in a way that makes consumers recognize the long-term costs of operating the vehicle (which they would otherwise be inattentive to) by embedding them in the upfront purchase cost. The increase in social welfare from this type of “internality” tax holds even if there are no externalities (carbon emissions etc.) from the burning of the additional gasoline.

To say that taxing people to make them better off is politically infeasible (and undesirable) is an understatement. But the idea that people make mistakes in trading off current costs and longer terms costs is well-established in the literature. It is worth thinking of less paternalistic ways to help people make tradeoffs that ex post, they would agree made them better off. The authors offer four broad categories of such policies all of which try to target the policy to customers most likely to be inattentive. While any of these may work theoretically it is often quite difficult to target customers who are inattentive. How do you tell if a customer is inattentive to gas prices or really just likes trucks?

Imagine you are in the market for a new light truck. Let’s say it’s a new Ford Explorer. You go to your favorite Ford dealer and the helpful salesperson tells you that she has two 2011 Explorers with identical performance and features. One of these cars costs $2000 more and gets 49.6 mpg, the other gets 27.5 mpg. You are the type of driver who buys a new car with cash every 10-12 years and drives it into the ground. So you do some quick calculations using a 7% discount rate and figure that you will save nearly $5,200 in gasoline over the life of the car. That’s a net gain of $3,200 over the life of the car. Moreover, you will recoup your additional expenses in the first four years of ownership. Your friend who is shopping with you, finances all of his vehicles. But you run the calculations for him and discover that even if he finances the car over 60 months, he will save $12 per month during the loan period.

The goal of the proposed NHTSA rule is to increase the average industry fleet-wide fuel economy for cars and light trucks to 40.1 mpg by 2021 and to 49.6 mpg by 2025. The simultaneous rule by EPA, which is based off the fuel economy standards proposed by NHTSA, limits greenhouse gas emissions from vehicles to 163 grams per mile (g/m) by 2025. The claim is that these standards can be met and in so doing, consumers will actually save an average of $3,200 per vehicle over the life of a new car. We are from the government and we are here to help!

There is a lot of flexibility built into this rule. There are options to earn credits for over-compliance, which can both be carried forward (banking) and carried back (borrowing). There are allowances for credit transfer between cars and light trucks and even credit trading across manufacturers. There is also plenty of flexibility built into the GHG standards allowing for credits for air-conditioning improvements, off-cycle improvements, an electric vehicle multiplier, and credits for hybridization of full size trucks. All of these sources of regulatory flexibility should lower the costs of attaining the standard and allow each manufacturer to attain the standard in a cost-effective way given its fleet.

Still, the presentation of benefits and costs suggests a free lunch. Actually, a lunch that you are paid $3,200 to eat. Even with all of these cost-lowering flexibility measures, this seems hard to swallow. And it should be, because it is wrong.

To see why the costs are much higher than the analysis suggest, image you are back at the Ford dealer. The salesperson presents a new 2011 Explorer, which gets 27.5 mpg and tells you that this car retails for $22,000. Then she shows you a 1997 model-year Ford Explorer that has never been driven or owned (the odometer reads 0), but this 1997 Explorer has been tweaked to get 49.6 mpg. She’ll sell you this modified 1997 model Explorer for $24,000. What do you choose? Many of you will get the 2011 model with the worse gas mileage. Some of you might buy the 1997 model car with the better gas mileage, but clearly your cost is not just $2000. It’s the monetary costs ($2,000) plus the difference in performance/features between the 1997 and the 2011 model.

What the benefit-cost analysis conducted by NHTSA and EPA says is that by 2025 the car manufactures can produce a car that has the same performance as 2011 cars on the market today, but gets double the gas mileage. This car will cost $2,000 more than cars sold today. But nobody expects that absent this regulation 2025 models will perform like 2011 models. We expect innovation in performance, features, safety, etc. The real cost of the regulation is how much of this we will give up between now and 2025 in order to get a doubling of the fuel economy of vehicles.

I have blogged before about my frustration that the right insists that all regulation is job-killing. But I’m equally frustrated when the left insists that regulations are costless. Maybe doubling fuel economy is a good idea. Maybe the benefits to us of reduced carbon emissions, reduced oil consumption, increased national security, are worth trading off more horsepower, torque, or other features. Maybe not. But that is what a benefit-cost analysis should be helping us decide. We want jobs, economic growth, clean air, clean water, good schools, etc. The challenge is how to balance out those competing desires with our limited resources. It may not be a great sound bite, but it is the truth.

About this Site

Welcome! On this site you can find information about my research and teaching. This site also contains my course blogs. The Environmental Economics blog was created as part of a Fall 2011 course in Resource and Environmental Economics at the Nicholas School of the Environment, Duke University. The Environmental Policy Blog was created as part of a Fall 2012 course on U.S. Environmental Policy. Posts are very intermittent when these courses are not in session. You can subscribe to the RSS feed or follow me on twitter @loribennear.